3Q 2018 AMCO Commentary

The U.S. economy and equity markets are the standout performers in 2018, but risks are forming at home and overseas that could cloud the picture. Rising interest rates and a brewing trade war top the list of worries.

The Fed has said it will keep raising interest rates until it sees evidence that higher rates are hurting the U.S. economy. The risk is that the economic evidence reveals itself too late and the Fed ends up overshooting.

The longer the U.S.-China trade disputes lasts, the greater the risk that one side or the other will overplay their hand, and that markets and the global economy have to deal with the unpleasant aftermath.

The U.S. economy and equities are thriving so far in 2018. GDP growth is at its highest in a decade, and there’s also ultra-low unemployment, tame inflation, soaring consumer confidence, robust earnings and a stock market that has hit new record highs.

Other major economies are not faring nearly as well. Europe’s growth rate is waning, while emerging markets – last year’s standout performer – are struggling in the face of high debt, currency weakness, costly oil and trade worries.

There is growing concern that what’s ailing non-U.S. economies and markets could soon spread to our shores in a reversal of the old saying, “When America sneezes, the rest of the world catches a cold.” Early estimates for third-quarter GDP are already being revised down, in large part due to slowing exports contributing to a wider trade deficit.

We think the risk of contagion is real given monetary tightening and trade tensions, and that policymakers should weigh the potential ramifications of their actions during this tenuous time.

FED TIGHTENING

The Federal Reserve raised short-term interest rates in late September – it was the third rate increase in 2018 and the eighth since the current tightening cycle began in late 2015. Its rate actions could lead to dollar appreciation, which would also act as yet another source of monetary tightening.

Higher rates and a mightier greenback would add to the woes being experienced in emerging markets – EM equity and debt are both among the worst-performing asset classes so far this year. EM represent a sizeable chunk of the global economy and they are growing at a faster pace than the developed world, so their health matters to U.S. investors.

At home, there’s the flattening Treasury yield curve to think about. The worry is that a flat yield curve often leads to an inverted curve (2-year Treasury yields greater than 10-year yields), which over time has been a reliable signal of heightened recession risk.

The Fed has said it will keep raising until it sees evidence that higher interest rates are hurting the U.S. economy. This is fairly standard thinking during tightening cycles, and the Fed’s new leadership wants to establish its credibility with markets. The risk is that the economic evidence reveals itself too late and the Fed ends up overshooting on rates.

TRADE TURMOIL

Worries about global trade relationships are steady headline fodder, but more than six months after President Trump first proposed tariffs on certain metals imports, markets are still discounting the likelihood that current tensions – particularly between the White House and China – will devolve into a full-blown trade war.

From our perspective, it’s still unclear how much of the U.S. tariff action against Beijing is bare-knuckles negotiating aimed at creating more balanced trade between the countries and how much is a view in Washington that China’s trade tactics – including compelled technology transfers – present a long-term threat to the U.S. economy.

What is clear that a number of companies with international supply chains don’t want to get wrong-footed. They are holding off on capital investments decisions while waiting for more clarity. Less capital spending could lead to less output and less hiring and thus affect growth.

The U.S. may appear to have an advantage in the dispute because we import so much from and export so little to China – we can impose more tariffs than they can. But China has options beyond tariffs, including a currency devaluation or selling down their huge inventory of Treasuries.

The longer this goes on, the greater the risk that either side or both overplay their hand, and that markets and the global economy will have to deal with the unhappy consequences.

PORTFOLIO POSITIONING

The USAA asset allocation portfolios are currently neutral on equities and fixed income.

Within equities, we maintain a full overweight non-U.S. developed markets, with a slightly larger allocation to Japan than Europe. Valuation-wise, Japan is one of the cheaper regions within DM, and we see better prospects for profitability.

We hold a partial overweight to emerging markets based on relative valuation and earnings growth potential. In the near term, we are cautious about negative impacts rippling out from the trade-related tensions between the U.S. and China, which has contributed to currency weakening. Longer-term, we believe EM has more upside potential than DM based on fundamentals.

We are underweight U.S. large cap and small cap stocks, as expected returns stand to be lower than other regions given higher relative valuations. We are also slightly underweight investment-grade corporate bonds, as we see an imbalance between risk and expected returns, and neutral on high-yield credit.

As always, we advise members investing for the long term to expect the unexpected and not get swept up in short-term market moves. Our consistent advice is to remain focused on the long-term investment plan that you have put so much thought into. For those uneasy about market risk in general or with concerns about too much exposure to specific asset classes, we recommend consulting with a USAA advisor.

This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.

Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.

The fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss.

Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.